Preliminary Draft September 2008 On the Case for a Balanced Budget

This paper uses the political economy model of Battaglini and Coate (2008) to analyze the impact of a balanced budget rule that requires that legislators do not run deficits. It considers both a strict rule which cannot be circumvented and a rule that can be overridden by a super-majority of legislators. A strict rule leads to a gradual but substantial reduction in the level of public debt. In the short run, citizens will be worse off as public spending is reduced and taxes are raised to bring down debt. In the long run, the benefits of a lower debt burden must be weighed against the costs of greater volatility in taxes and less responsive public good provision. To quantify these effects, the model is calibrated to the U.S. economy. While the long run net benefits are positive, they are outweighed by the short run costs of debt reduction. A rule with a super-majority override has no effect on citizen welfare or fiscal policy. Marina Azzimonti Department of Economics University of Texas Austin TX 08544 [email protected] Marco Battaglini Department of Economics Princeton University Princeton NJ 08544 [email protected] Stephen Coate Department of Economics Cornell University Ithaca NY 14853 [email protected] This is a report on work in progress prepared for the Wallis Conference on Political Economy at the University of Rochester. For research assistance we thank Kazuki Konno, Tim Lin, and Matthew Talbert. For helpful comments and encouragement we thank Marco Bassetto, Narayana Kocherlakota, Nancy Stokey, and seminar participants at Carnegie Mellon University, the LAEF Conference at U.C. Santa Barbara, the Midwest Macroeconomic Meetings at the University of Pennsylvania, the Minnesota Workshop on Macroeconomic Theory, North Carolina State University, the Society for the Advancement of Economic Theory Meetings at Kos, the Society of Economic Dynamics Meetings at Prague, University of Southern California, University of Toronto, the Wegman’s Conference at the University of Rochester, and the Wharton School. Further comments are most welcome.